MONETARY AND EXCHANGE RATE POLICY FOR MEXICO
Key Issues and a Proposal
by Guillermo A. Calvo*
University of Maryland
June 8, 1997
* I am thankful to Sebastian Edwards, Everardo Elizondo, Salvador Kalifa, Enrique Mendoza, Agustín del Río,Adrián Rodríguez, and Raúl Treviño for useful comments on an earlier draft. I am, however, solely responsible forany errors or opinions.
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I. Introduction
In these notes I lay out basic considerations which I believe are relevant for the design of
monetary/exchange-rate policy, MEP, in Mexico. In my view, there are no ‘magic’ formulas.
For some countries, an iron-clad currency board may be a desirable arrangement, while for others
flexible exchange rates would be appropriate. This is so because ‘money’, unlike regular goods
like bread, derives its value from convention, institutions and, more than any other good, from
expectations. Thus, a key consideration in the design of MEP is the credibility of policymakers -
- the latter being heavily determined by history and institutions which are, by necessity, country-
specific.
Section II discusses some traditional goals of MEP, while Section III examines the role of
credibility and flexibility to ensure its effectiveness. Section IV studies the recent experience in
Mexico and shows that the proximate case for the 1994 financial debacle was a failed attempt at
interest-rate smoothing, coupled with having ignored the role of external factors. Moreover, this
section briefly examines MEP after the crisis. It concludes that MEP is highly accommodative
and may have contributed to the existence of a “peso problem.” The latter, in turn, may give rise
to further real appreciation of the currency. Section V presents a brief summary of the pros and
cons of different MEPs. This is complemented in Section VI with a discussion of other policies
and considerations that are essential for the sustainability of any MEP. More specifically, I will
discuss the role of fiscal policy, management of domestic public debt and the role of the financial
sector.
Section VII offers some ideas for a MEP for Mexico based on previous considerations. In
a nutshell, I propose adopting a system of flexible exchange rates, much like the present one, but
with a longer horizon and complemented with a sliding floor on the nominal exchange rate to
prevent large and sudden currency appreciation. Furthermore, I argue in favor of free-floating
interest rates and no controls on capital mobility, except for reserves requirements aimed at
preventing sudden and sizable growth in bank credit. Comparison with present MEP and some
criticisms are discussed in Section VIII. Questions about long-term goals and transition are
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presented in Section IX. Appendix I examines a simple formal model to rationalize the effect of
the MEP after the December 1994 crisis, while Appendix II analyzes some technical implications
of the proposed exchange rate rule.
II. Objectives of Monetary and Exchange Rate Policy
The central objective of monetary/exchange-rate policy, MEP, is (1) price stability,
meaning a stable price level or stable, and low, rate of inflation. However, usually MEP is also
aimed at some or all of the following three objectives: (2) preventing financial crises, (3) full
employment, and (4) growth. Objective (2) was, for instance, mentioned in connection with the
1987 stock market crisis, when the Fed aggressively pumped in liquidity to prevent a financial
collapse. On the other hand, objective (3) was installed in many central banks’ charts after the
1930 Great Depression. Finally, objective (4) takes different forms. Sometimes it is just
“growth” but more often it is “the preservation of international competitiveness” to ensure
growth. East Asian countries appear to have been especially sensitive about the competitiveness
issue, a fact that is reflected in stable real exchange rates (i.e., the relative price of tradables with
respect to nontradables) in the region.
A central lesson from theory and experience is that it is difficult, if not impossible, to
simultaneously satisfy all the above objectives. Thus, countries are typically forced to choose.
Argentina, for example, chose price stability and adopted a Currency Board, while Chile gave
some weight to international competitiveness and targeted the real exchange rate, among other
variables. Argentina has achieved zero inflation, while Chile’s inflation has only recently fallen
below double digits. Furthermore, Mexico was afraid of financial collapse in 1994 and tried to
cushion the rise in peso interest rates. Pursuing this objective (number (2) above) and price
stability (number (1) above) proved impossible, and objective (1) was abandoned in December.
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III. Effective MEP: Credibility and Flexibility
The effectiveness of MEP depends on an array of factors. Fundamental factors will be
discussed in Section VI below. At this juncture, I will examine two factors that are essential for
MEP’s effectiveness, but which are less well understood, namely, credibility and flexibility. It is
not enough to make announcements if they are not credible, and rules have to be flexible enough
for policy to be able to accommodate unexpected shocks. Ignoring the importance of these
factors has proven socially costly, and even disastrous for the reputation of the policymakers.
1. The Role of Credibility
Money, specifically fiat money, unlike regular commodities, is intrinsically worthless.
Pesos are exchanged for intrinsically valuable goods not because anybody wants pesos but
because the receiver of pesos believes he can find another trusting individual like himself who
will accept pesos in exchange for valuable goods. Economists are still struggling to understand
why money has value but, as the previous observation suggests, it is widely agreed that the value
of money in terms of goods owes a good deal to institutions and social conventions. A change of
social conventions or institutions is unlikely to radically change the relative price of bread in
terms of apples, but it can dramatically change the value of pesos in terms of bread. Just imagine
Banxico announcing that the peso is no longer legal tender in Mexico. The value of a peso will
surely plummet, and only a chronically absent-minded individual would part with a loaf of bread
for pesos!
In addition, and in contrast with standard goods, fiat money can be produced by
government at minimum cost. As with any other good, the value of money declines with its
supply (and also with the expectation that its supply will increase). Thus, the expected path of
money supply in a MEP will have direct impact on the value of money.
Consequently, the value of money depends on the usual interaction between supply and
demand, but money supply can easily be changed by policy. Combining this feature with the
observation that money’s value depends on convention and institutions, one can deduce that the
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value of money is highly sensitive to what people expect about future MEP and institutional
policy (e.g., independence of the central bank). Thus, the effectiveness of MEP depends, in an
essential way, on policy credibility. I will now briefly discuss two main factors that help to
ensure credibility.
In the first place, to be credible a policy has to be simple. Complex policies can only be
understood by a few. The others may miss the message and could even conclude that it is simply
a plot to give government a freer hand. In this respect, for example, setting a constant exchange
rate with respect to the dollar (like in Argentina) is a much simpler policy than a crawling peg
where the rate of crawl is a function of several indicators that few people understand.
Furthermore, for a MEP to be credible is has to constrain government’s future actions.
For example, a statement like “the Bank will favor ordered money and foreign exchange
markets”1 leaves the central bank with many degrees of freedom, and makes it difficult for the
private sector to figure out under what conditions the central bank will depart from other policy
announcements. Credibility is especially impaired if government has a track record of abusing
safety valves, as will be argued is the case in Mexico.
2. The Role of Policy Flexibility
Another desirable property of MEP is policy flexibility, namely, the ability to react to
unexpected shocks. Policy flexibility entails the ability to adjust money supply or the exchange
rate in response to unanticipated shocks.2
Flexibility is especially useful to deal with unanticipated shocks in financial and labor
markets. Flexible MEP would, for example, allow the central bank to extend credit to the
banking sector in response to a massive deposit withdrawal, thereby preventing a financial crisis.
1 My translation of “El Banco propiciará el orden en los mercados cambiario y de dinero” in Exposición sobre laPolítica Monetaria para 1997, Banco de México, January 1997, p. 31.
2 Notice that policy flexibility is very different from the flexibility of certain key variables, like the exchange rate.To illustrate, a fully-floating exchange rate regime with a constant money supply (irrespective of shocks) is aninflexible policy, because the variable under control, namely money supply, is inflexible.
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This policy was adopted by Banxico during 1994. Furthermore, flexibility is useful to deal with
real shocks that call for a change in the real wage. Typically, wages in the organized labor
market are set in nominal terms. Thus, a fall in real wages required by an unanticipated negative
shock (like an unanticipated fall in the price of oil) can be facilitated by an increase in money
supply or a currency devaluation. Without monetary accommodation, this type of shock may
result in protracted unemployment or capacity underutilization.
3. Interaction Between Credibility and Policy Flexibility
Arguably, MEP flexibility explains the relatively smaller collapse of output in Mexico
than in Argentina during 1995. In 1995 Mexico cut its current account deficit by about 8 percent
of GDP and output fell by about 6.4 percent. On the other hand, Argentina kept a constant
exchange rate and cut its current account deficit by about 2.5 percent of GDP and output fell by
about 4.4 percent. Thus, relative to the adjustment in the current account deficit, the negative
impact in Argentina was more than double that in Mexico (= (4.4/2.5)×(8/6.4) = 2.2).
Policy flexibility is highly valued in advanced countries like the US and Germany. Its
main drawback is that it may undermine credibility. As noted above, ensuring credibility may
require adopting sclerotic MEPs in which policymakers are impeded from nimbly reacting to
‘news’ -- just the opposite to flexibility. Thus, if policymakers exhibit a poor track record, like it
was the case in Argentina before the Convertibility Program, flexibility could even be
counterproductive. Instead of improving expected policy performance, flexibility may lead the
public to distrust MEP so much that it pushes the government into a bad-policy corner. For
example, if the public believes that flexibility will be used to finance politically motivated
government projects with central bank credit, a flexible MEP may raise inflationary expectations
and lead to massive capital flight (even though the government has no intention to use central
bank credit for political purposes). Capital flight, in turn, is typically associated with large
deposit withdrawals, forcing the central bank to extend credit to banks to prevent a major
financial crisis. Thus, although central bank credit would be extended for good reasons, the root
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of the resulting inflation would be the adoption of a flexible MEP under poor credibility
conditions.
IV. Mexico: Recent Experience
a. The Crisis of December 1994
Mexico is a clear case in which not all MEP objectives outlined at the outset can be
simultaneously satisfied. Figure 1 depicts an interesting relationship between inflation and the
real exchange rate (measured in such a way that an increase in the real exchange rate means real
currency appreciation). Figure 1 is based on monthly data and shows a clear negative
relationship between the rate of inflation and the real exchange rate: the more depreciated is the
currency in real terms, the higher is the rate of inflation. This suggests that attempts at stabilizing
the real value of the currency at low levels (objective 4 above) may be incompatible with low
inflation. Figure 1 suggests, in addition, that beyond a certain point, attempts at further
depreciating the currency in real terms may lead to steeper increases in the rate of inflation. The
same data is displayed in Figure 2 which shows that the steep rise of inflation in 1987 was
associated with a sharp decline in the real exchange rate.3
Mexico’s recent attempt to satisfy objective 2 (i.e., avoid financial crisis) by controlling
the nominal interest rate also proved counterproductive for objective 1 (i.e., price/inflation
stability). Figure 3 shows that Banxico was actually able to avoid a sharp run up on the CETE
rate before the 1994 crisis. This is a remarkable achievement given that the market expected a
devaluation around election time. The ‘trick’, however, was to change the composition of
domestic debt in favor of Tesobonos (a dollar-denominated asset) and, in the final stages, to
generate a large and unprecedented expansion of central bank credit to the banking sector (see
Figure 4). This policy was undertaken despite keeping a very stable Peso/Dollar exchange rate
3 For a more careful discussion of the relationship between inflation and the real exchange rate, see G.A. Calvo,C.M. Reinhart and C.A. Végh, “Targeting the real exchange rate: Theory and evidence,” Journal of DevelopmentEconomics, vol. 45, 1995, pp. 97-133.
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(see Figure 5). Thus, the expansion of central bank credit resulted in a massive loss of
international reserves despite the apparent stability of monetary aggregates (see Figures 6 and
7). On the basis of this analysis one could conclude that the December 1994 crisis was due to
Banxico’s stubborn pursuit of low nominal interest rates. In its defense, however, one could
argue that this BOP-crisis-prone policy may have been motivated by the feeling that the banking
sector was weak and would have been pushed to the brink of collapse if interest rates rose
steeply. This is further supported by recent studies that I will now summarize.4
The decline in US interest rates from 1989 to 1993 (see Figure 8) appears to explain the
big surge of capital flows into Latin America, particularly Mexico.5 Thus, the rise of US interest
rates in 1994 (see Figure 8) is likely to have caused capital to flow in the opposite direction. In a
recent study with Enrique Mendoza,6 we show that this is also reflected in a negative association
between US short-term interest rates and Mexico’s monetary aggregates (specifically, M2).
Thus, we argued that the December crisis owes a great deal to the increase in short-term US
interest rates during 1994 (see Figure 8). Without Banxico engaging in open-market operations,
we estimated that monetary aggregates would have exhibited substantial contraction, or interest
rates would have risen sharply.
Therefore, external factors may have exacerbated the crisis, which helps to rationalize
Banxico’s policy during 1994. However, this does not exonerate Banxico from not having
explicitly incorporated into their technical analyses the possible effect of external factors.7
4 These studies focus on economic factors exclusively. Admittedly, however, the timing of peso runs was closelylinked to the dramatic political episodes of 1994.5 See G.A. Calvo, C.M. Reinhart and L. Leiderman, “Capital Inflows and Real Exchange Rate Appreciation in LatinAmerica,” IMF Staff Papers, 40, 1993, pp. 108-151.
6 In G.A. Calvo and E.G. Mendoza, “Mexico’s balance-of-payments crisis: a chronicle of a death foretold,” Journalof International Economics 41, 1996, pp. 235-263 (published in Spanish as “La Crisis de la Balanza de Pagos deMéxico” Investigación Económica, enero-marzo, 1997, No. 219, pp. 13-51).
7 Economists at Banxico were well aware of the above-mentioned papers and dismissed them out of hand. Thefeeling was that Mexico had “graduated” into the First World, and that the early 1990s’ expansion of monetaryaggregates entirely reflected this enhanced standing, not external factors.
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Another important phenomenon in 1994 was the increasing mismatch between short-term
liabilities and liquid international reserves during the year (see Figure 7). To be sure, this type of
mismatch was not unprecedented for Mexico since, as shown in Figure 7, it had been exhibited
for most of the 1989-1991 period. However, conditions in 1994 were very different because, as
argued above, capital inflows were beginning to slow down. In addition, a large share of
domestic public debt was denominated in dollars (Tesobonos) and was held abroad .8 The
refusal of the capital market to refinance Tesobonos when the crisis erupted was the last straw.
These remarks suggest that
1 Real exchange rate targeting could be inflationary,
2 Interest rate targeting or a MEP designed to prevent financial crises could
raise suspicions that Banxico will accommodate any kind of shock to monetary
aggregates, and
3 MEP should take into account external factors and the maturity structure
of government obligations relative to that of international assets.
b. Mexico after the Crisis
These remarks do not intend to be exhaustive. The main purpose is to offer a brief
assessment of monetary policy since the December 1994 crisis. The central characteristic of this
policy is the adoption of a dirty float system for the exchange rate and, given the circumstances,
moderate devaluation. Instead of taking advantage of further devaluation to clean up the banking
system, stability of the exchange rate was defended with high interest rates. Even the possibility
of using the inflation tax to lower nominal bank liabilities in real terms was partially obliterated
by adopting the UDI in the financial system.
8 P. Garber and S. Lall “Derivative Products in Exchange Rate Crises” (presented at the Federal Reserve Bank ofSan Francisco’s conference on “Managing Capital Flows and Exchange Rates: Lessons from the Pacific Basin,”September 26-27, 1996) shows that some of these holdings were associated with repo agreements with Mexicanbanks, and contributed to the ferocity of the run.
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In addition, a remarkable feature of monetary policy in Mexico is that the exchange rate
appears to float freely and, yet, it has exhibited a high degree of stability. Werner shows, for
example, that after mid-1995 exchange rate volatility in Mexico does not exceed that of other
major currencies that float against the dollar.9 This is all the more surprising given that the
volatility of monetary aggregates in Mexico appears to be much higher than in advanced
industrial countries like Canada and Germany which are in Werner’s comparison list. Part of the
explanation is that Banxico accommodates demand for liquidity on a day-to-day basis. See, for
example, Figure 9 which depicts monthly changes of monetary base. The pattern followed by
this variable has remained largely invariant to the change in monetary policy. Thus, contrary to
the textbook case of floating exchange rates, in which money supply is constant or follows a
straight line, Figure 9 shows the monetary base accommodating to seasonal and other factors in a
highly flexible way. Besides, it would be unlikely for someone unaware of the dramatic changes
in Mexico that took place in 1995, to infer their existence by just looking at Figure 9.
To the extent that Banxico could not (or would not) fully accommodate the demand for
monetary base, the potential excess demand or supply for base must have been reflected on the
exchange and interest rates. Therefore, it is not surprising to find that these two variables’
volatilities increased relative to the Pacto period: increased volatilities is by no means a proof
that the post-January-1995 MEP is flawed. Actually, if these volatilities had not risen, it would
be compelling proof that Banxico had completely backed away from floating.
However, if exchange rate expectations were stable -- dictated, for example, by the
expectation of a seasonally-adjusted base growing at a constant rate -- then interest rates
differentials (between, CETEs, say, and US T-Bills) should be just a few percentage points.
This is not the case in Mexico, however, as depicted by Figure 10. The large differentials are
compelling indication that the market expects devaluation spikes. Notice that if devaluations and
appreciations were equally likely then (in a risk-neutral world) no devaluation interest premia
9 See A. M. Werner “Un Estudio Estadístico sobre el Comportamiento de la Cotización del Peso Mexicano frente alDólar y de su Volatilidad,” Documento No 9701, Banco de México, March 1997.
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should emerge. Thus, the market seems to be expecting an occasional but substantially upward
correction in the exchange rate (sometimes called “peso problem”). Peso problems are known to
cause real currency appreciations (of a disequilibrium type) in staggered-prices models, i.e., in
economies in which most prices are sticky in the short run, and are revised in a staggered fashion
over time, as in Mexico.
Moreover, if devaluation expectations were stable, there would be a negative association
between changes in the exchange rate (i.e., devaluations) and interest rates (see Appendix I).
However, as depicted in Figure 11, this was not the case in Mexico after June 1995. As argued
in Appendix I, this positive association could be due to the market’s expectation that a
devaluation will be followed by further devaluations. The time series on “cortos” establishes that
Banxico has used the policy to prevent sharp currency appreciation or depreciation. This is
largely a gesture (since quantities involved are extremely modest) that may be taken to mean that
Banxico is intent on being less (more) accommodative in case of a currency devaluation
(appreciation). Thus, “cortos” may initially dampen exchange rate changes. This would be the
end of the story if Banxico’s monetary stance remained unchanged. However, once the critical
period elapses, Banxico may be expected to return to a more accommodative stance (one good
reason being that Banxico itself explicitly says so in its policy announcement). Consequently,
rational individuals are likely to expect further devaluation in the near future. An implication of
this is that the market believes that Banxico is likely to follow accommodative MEP, only
transitorily “leaning against the wind” in the face of sharp changes in the exchange rate. This
belief is likely to be further exacerbated by the fact that Banxico’s policy announcements cover
short periods of time -- typically no longer than a year.10
To summarize, the market seems to perceive MEP in Mexico as being largely
accommodative. Intervention through open market operations “cortos” has been highly
successful given the modest sums of money involved in that connection. However, the resulting
10 Interestingly, the last two devaluation spikes took place towards the end of calendar years (November 1995 andOctober/November 1996), prior to the major policy announcements for the following year.
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sequence of periods of tranquillity separated by sharp devaluation, runs the risk of inducing real
currency appreciation (of the disequilibrium type). So far this has been no serious problem
because the real exchange rate was moving towards it long-run equilibrium level after exhibiting
sharp depreciation in 1995. However, the situation is somewhat different now. Most analysts
agree that the real exchange rate is close to its long-run equilibrium or is even appreciated with
respect to the latter. Thus, continuation of the present MEP may start to be costly.
In closing, I would like to point out that the present policy has still not been “tried by
fire.” Macroeconomic variables like the trade balance and the current account have shown no
sizable disequilibrium and, as pointed out above, the real exchange rate shows no serious sign of
appreciation (contrary to December 1994). Thus, the chances of having to hold on to tight
monetary policy in the face of real strain are momentarily small. However, this situation may
change in the future. Actually, I am afraid that the present accommodative stance may even
contribute to the generation of macroeconomic disequilibrium. For that reason, I believe this is
the time to act, and better sooner than later.
V. Exchange Rate Systems: Pros and Cons
1. Floating Exchange Rates
“Pure” floating exchange rates is defined as a system in which the exchange rate is fully
determined by the market, and there is no attempt on the part of the monetary or fiscal authorities
to affect it. Monetary aggregates or key interest rates are exogenously determined by the
monetary authority and are unrelated to the exchange rate. In practice, however, “pure” exchange
rates are rare. Even countries like the US and Germany occasionally intervene in the foreign
exchange market to prevent ‘excessive’ currency appreciation or depreciation. However,
conceptually it is useful to start the discussion from the “pure” case.
The main benefit of this type of regime is that monetary policy can be exclusively utilized
to pursue domestic objectives, e.g., price stability. Moreover, this is an attractive policy under
conditions of low international reserves, as in Mexico today. No foreign exchange intervention
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means that the monetary authority does not intervene selling foreign exchange to ensure the
international value of the currency and, thus, on this account there is no risk of a BOP crisis.
However, floating rates are not impervious to credibility problems. Thus, for example, if
the public believes that higher inflation is in the offing, the nominal exchange rate will tend to
devalue, setting the stage for higher inflation. If money does not accommodate higher expected
inflation, the price level may rise faster than the nominal exchange rate, provoking real exchange
rate misalignment.
Naive commentators occasionally say that floating exchange rates could never be
associated with real exchange rate misalignment because the nominal exchange rate is
determined by the market. This is, however, a mistake. Example 1: floating rates in Brazil
during the Cruzado plan resulted in a significant real appreciation of the currency. Example 2:
the US dollar dramatically appreciated in real terms in the first half of the 1980s.
a. Stabilizing the Real Exchange Rate.
Real exchange rate misalignment and volatility are major concerns of floating exchange
rate regimes. This partly explains why it is so difficult to find “pure” examples of floating
exchange rates. Countries intervene to alleviate volatility and to avoid misalignment. Under
normal circumstances, volatility can be alleviated by manipulating some key domestic interest
rate (like the CETE rate). Countries like El Salvador and Egypt have succeeded in largely
stabilizing their exchange rates by resorting to this type of policy. Mexico in the period
December 1995-October 1996 is another case in point. Misalignment, on the other hand, is
harder to offset with interest-rate policy.
Volatility differs from misalignment in that the former reflects transitory factors, while
the latter is a result of more permanent phenomena. A temporary appreciation of the currency
can simply be offset by a temporary cut in interest rates. In contrast, the existence of
misalignment implies that the current levels of exchange rate and prices would be far from
equilibrium (in some way defined) for an extended period of time. Volatility could be easily
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identified because it involves unusual but reversible changes in the exchange rate. Misalignment,
on the other hand, is harder to detect. It takes place in slower motion and lasts longer. It is
difficult to ascertain if it is due to ‘fundamentals’ or to macroeconomic disequilibrium. Besides,
trying to offset perceived misalignment could, in fact, be counterproductive.
To illustrate, consider the kind of appreciation discussed in Section V.1, stemming from
the expectation that inflation is bound to increase. To alleviate its effects, the monetary authority
increases money supply, resulting in a nominal depreciation of the currency. However, the
public may see this as a confirmation of slack monetary discipline. Thus, prices rise again,
offsetting the effects of the expansionary policy, and further undermining policymakers’
credibility.
Stabilizing the exchange rate by resorting to interest-rate policy may result in large
swings in the short-term rate of interest. For example, consider a sharp rise in interest rates.
This will have an immediate impact on the cost of serving short-term domestic public non-
indexed debt, worsening the fiscal balance. If the public takes this as a harbinger of higher
inflation, then the nominal interest rate will tend to stay higher, making a dent in the fiscal
budget, as expected by the public. Obviously, the relevance of this destabilizing effect will be a
function of the size of short-term non-indexed public debt. Hence, this is another example in
which the type of domestic public debt affects the effectiveness of MEP.11
An even more relevant example for Mexico is when the central bank stands ready to bail
out the banking system in case nonperforming loans become unsustainable. In this case there is
an implicit public debt which increases as a result of a sharp hike in interest rates. If the public is
aware of that, inflationary expectations are likely to increase with the rate of interest, leading to
the same type of vicious cycle highlighted above.
11 For a conceptual discussion of these issues, see G.A. Calvo Money, Exchange Rates, and Output (Cambridge,MA: MIT Press, 1996), Part IV. For a discussion in the context of Argentina, see R.B. Fernandez “What HavePopulists Learned from Hyperinflation,” in R. Dornbusch and S. Edwards (editors) The Macroeconomics ofPopulism in Latin America (Chicago, IL: The University of Chicago Press for the NBER, 1991).
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b. Interest-Rate Smoothing.
Financial innovations in the last 25 years have diminished the relevance of monetary
aggregates as barometers of aggregate demand. Thus, many advanced countries use short-term
interest rates as indicators of the state of aggregate demand, and conduct MEP so as to stabilize
those rates around a target level. The target itself is occasionally revised if other indicators show
a surge or contraction of economic activity or inflation.
Thus, given an interest rate target, if short-term interest rates rise, the monetary authority,
operating under floating exchange rates, will expand money supply through open market
operations (i.e., buying domestic public debt). Likewise, monetary contraction will ensue if
interest rates fall.12
The policy’s central objective is to accommodate money supply to money demand and, in
this fashion, prevent the spillover of monetary disequilibria into the real economy. If money
market disequilibria affect the exchange rate, then interest-rate smoothing could also help to
stabilize the real exchange rate. However, these two targets -- stability of interest rates and real
exchange rates -- may be mutually incompatible. This is not a major concern in relatively closed
economies like the US, but it may be a relevant consideration for a country like Mexico.
Interest-rate smoothing is particularly ill-advised for countries suffering from credibility
problems. This is so because interest rates may rise, for example, simply because the private
sector expects an impending devaluation of the currency. An example is Mexico around election
time in 1994. Under those conditions, if the monetary authority tries to lower interest rates, it
will expand money supply, a policy that will likely be taken by the public as corroborating their
high-inflation expectations. Therefore, instead of pushing interest rates back to target, this policy
12 It is interesting to note that this policy has been systematically criticized by the academic literature claiming that itwill either fail to provide an effective nominal anchor, or trigger instability. The classical reference in this respect isK. Wicksell Lectures on Political Economy (New York, NY: Reprints of Economic Classics, A. M. KelleyPublishers, 1967.
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may result in even higher interest rates. Finally, it should be noted that when credibility is at
stake, interest-rate smoothing may not be desirable even though the above-type instability does
not arise. This is so because money supply accommodates expectations, making MEP less
effective as a nominal anchor.
c. Dirty Float
In practice there are few instances of pure floating. The government manipulates the
nominal exchange rate by resorting to foreign exchange intervention or to indirect methods. I
will refer to the latter because they are especially relevant for present-day Mexico.
The exchange rate depends, among other things, on the supply of domestic currency and
the domestic interest rate. Thus, a central bank can affect the nominal exchange rate by changing
money supply (e.g., open market operations) or by changing the interest rate on money
substitutes. In addition, given that the money market is so sensitive to expectations, the central
bank can have an impact on the exchange rate by sending a strong signal to the market that it is
prepared to take swift and decisive action in case the exchange rate does not move in the desired
direction. I believe this helps to explain the surprising stability of the exchange rate in Mexico
during most of 1996. In this context, it would be disingenuous to claim that the government
follows a clean float because, for instance, it does not intervene in the foreign exchange market
and open market operations are quantitatively insignificant.
Dirty floats have several drawbacks. In the first place, the private sector has to guess the
implicit central bank objectives. This introduces noise into the system, is likely to raise interest
rates and, therefore, is inimical to growth. Second, the active presence of the government makes
it liable to criticisms from politicians and the public if the exchange rate behaves in a way that is
considered undesirable. Thus, since exchange rate volatility is never welcome, it is not unusual
for central banks operating a dirty float to step in to prevent wide exchange rate fluctuations. The
main problem with this kind of intervention is that the central bank has to tell apart trend from
volatility. Since this is very hard in practice, the monetary authority may end up squashing, or
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threatening to squash, even minimal tremors from the exchange rate. As a consequence, ex post
the nominal exchange rate would be highly stable.
Consequently, a dirty float may converge to a system in which the exchange rate is stable
for some periods of time, and suffers one-step corrections occasionally. These corrections are
usually painful because they put to question the ability of the MEP to keep a stable environment
unless, of course, the MEP would be consistent with a constant exchange rate.
d. In Sum
Floating exchange rates are attractive when the stock of international reserves is low. A
major drawback is potential real exchange rate volatility. Fortunately, under normal
circumstances volatility can be attenuated by adjusting short-term nominal interest rates.
However, if the country is hit by large shocks, or credibility is at stake, interest rate policy could
be ineffective or simply counterproductive.
Interest-smoothing under floating exchange rates is ill-advised when the monetary
authority has a reputation of being highly accommodative.
A dirty float system is questionable because it either causes unnecessary noise, or
artificial stability followed by sporadic and large shocks.
2. Fixed Exchange Rates
In a “pure” fixed exchange rates regime, the monetary authority sets a constant exchange
rate (against some dominant currency or a currency basket) and stands ready to buy and sell
foreign exchange to sustain the chosen exchange rate. No foreign exchange or capital mobility
controls are imposed.
The fixed-rates MEP targets a price (the exchange rate), and in the “pure” case monetary
aggregates are determined by the market. This type of system has been adopted by many
countries, although not necessarily in its “pure” form or under strict fixity. It is appealing to
countries with a poor track record of monetary management (e.g., Argentina, Poland), and to
countries that wish to be integrated into a free-trade area (Spain, Portugal). To effectively
function, this type of regime requires the monetary authority to have enough international
17
reserves. How much is ‘enough’ depends on the circumstances and the volatility of monetary
aggregates and short-term domestic debt.13
a. Currency Board. Full Dollarization
This is the system adopted in Argentina and Hong Kong. In this system the exchange rate
is fixed against the dollar, say, and money supply (specifically, the monetary base, i.e., liquid
liabilities of the central bank = money in circulation + deposits of other banks in the central
bank) can only increase (decrease) as a result of purchasing (selling) foreign exchange valued at
the fixed exchange rate.14 In the “pure” case, the monetary authority’s accumulation or
decumulation of foreign exchange is exclusively linked to money supply, and the initial stock of
foreign exchange is equal or exceeds base money.
This is a very solid system from a monetary point of view because there cannot be
successful runs against the currency: the central bank always has enough reserves. The main
drawback is that banks are left without a “lender of last resort.” Thus, if there is a run against
deposits (as in Argentina in the first quarter of 1995 when bank deposits fell 18 percent with
respect to their December 1994 level) the central bank would be unable to make loans to banks to
stave off a liquidity crunch.15 (Notice that this type of policy would stand in sharp contrast to the
one followed in Mexico during 1994 (recall Figure 4).)
Currency Board supporters would reply to the above observation by saying that a lender
of last resort is needed only if banks believe that the central bank will come to their rescue in case
13 For a more detailed discussion of these issues, see G.A. Calvo “Capital Flows and Macroeconomic Management:Tequila Lessons,” International Journal of Finance Economics, vol. 1, 1996, pp. 207-223, and “Why is the Market soUnforgiving?: Reflections on the Tequilazo,” translated into Spanish by ITAM.
14 In practice there are exceptions but it is not worth discussing them here. For a recent discussion of CurrencyBoards, see S. H. Hanke, L. Jonung, and K. Schuler Russian Currency and Finance: A Currency Board Approach toReform (London: Rutledge, 1993).
15 It is worth pointing out that Argentina offset the credit contraction implications of the sharp fall in bank depositsby lowering reserve requirements. As a consequence, bank credit fell by only about 3 percent.
18
of financial stress. A lender of last resort would not be necessary if it was credibly announced
that the central bank would not perform that function under any circumstance. According to this
school of thought, if the announcement was credible, banks would radically alter their behavior
and hold enough liquidity to cover themselves against a run on bank deposits.
Interestingly, as of March 14, 1997, Banxico’s Net International Reserves were
N$ 86,036 million at the market exchange rate, whereas the Monetary Base was N$ 76,958
million.16 Thus, a “pure” currency board would be feasible. However, if the central bank was
responsible for all bank deposits, then a concept like M2 (which includes bank deposits and
acceptances) is more relevant than the Base. Unfortunately, M2 exceeds N$700 billion which is
almost 10 times Net International Reserves. In addition, the stock of CETEs outside banks is
around N$ 50 billion. Thus, on pure financial terms a Currency Board for Mexico would be
feasible only if it was highly credible that Banxico will not help (1) commercial banks in case of
a systemic run against bank deposits, and (2) the government to pay back its short-term debt in
case lenders refuse to roll it over. Notice that in the case of Mexico CETEs outside banks
amount to more than 60 percent Net International Reserves, but if BONDEs and Ajustabonos are
added, the total rises to about N$ 120 billion, or 150 percent Net International Reserves.
Full dollarization, as recently proposed by Rudi Dornbusch, represents one step further
than a Currency Board. As noted, Banxico has enough reserves to buy all the monetary base at
the current exchange rate. Thus, it would be possible to wipe out all outstanding pesos and
replace them with dollars on a voluntary basis. However, all debts will now be denominated and
payable in dollars. In particular, banks will fully operate in dollars but will not have the benefit
of belonging to the Federal Reserve System or to any other Washington institution designed to
prevent systemic bank runs in the US. Consequently, the vulnerabilities highlighted with respect
to currency boards are, if anything, magnified in a fully dollarized system.
16 Data from Comunicación Social No. 31, Banco de México, March 18, 1997.
19
The only possible advantage of dollarization over a currency board is that the former
makes it more difficult to play monetary tricks, since domestic currency would be driven out of
existence (except, perhaps, for small change like in Panama). As a result, a fully dollarized
system may enjoy greater credibility. However, country experiences are not very hopeful in that
respect. As the cases of Liberia and several provinces in Argentina show, dollarization does not
prevent the emergence of local monies. For example, local authorities could finance salary
payments by issuing small-denomination debt instruments. To ensure that these instruments are
accepted as a means of payment (and, thus, have a positive market value), authorities could
announce that they can be used to pay local taxes. This scheme has been utilized in Tucuman (a
province of Argentina) in several occasions, the most recent one being under the Convertibility
Program (currency board). Eventually, local monies could become dominant and gradual de-
dollarization will ensue.
b. Conventional Fixed Exchange Rates. Bands
Conventional fixed exchange rates allow greater flexibility of central bank credit. As a
consequence, BOP crises are more likely, making this kind of system less credible than an iron-
clad Currency Board. It has been amply demonstrated that imperfect credibility contributes to a
real appreciation of the currency and to a consumption boom during the early phases of
exchange-rate based programs. Eventually, boom gives way to bust, and appreciation to
depreciation. Unless international reserves are high, the downturn is likely to be accompanied by
a BOP crisis.17
Some economists suggest increasing the flexibility of this system by placing floatation
bands around a target exchange rate. This amounts to a fix/flex combination. Within the band
the monetary authority has greater freedom to affect money supply and interest rates like in a
17 See G.A. Calvo and C.A. Végh “Inflation Stabilization and Nominal Anchors,” Contemporary Policy Issues, April1994.
20
floating rates system. However, when poor credibility is a critical consideration, bands are of
little help. Thus, for example, before the December 1994 crisis in Mexico, the peso exchange
rate was stuck at the upper limit of the band, effectively making the system equivalent to one
with conventional fixed rates.
Under fixed exchange rates and perfect capital mobility, money supply is demand
determined. Attempts to independently determine money supply leads to immediate offsetting
capital flows. However, the monetary authority can still influence the demand for money by
affecting its interest rate. Fiat money pays no interest, but time deposits (which are a form of
money) do. The central bank can affect the deposit interest rate by offering banks attractive
assets. For example, the central bank could issue Certificate of Deposits that are attractive
enough for banks to hold. Competition will do the rest. In their attempt to attract deposits, banks
will tend to offer interest rates that are comparable to the CD rates.
Therefore, even under fixed exchange rates, interest-rate policy would be feasible and
could be used to alleviate volatility of international reserves and, to a lesser extent, to fight off
real currency appreciation.
c. Crawling Peg. PPP Rules
Here I will be referring to fixed but sliding exchange rate regimes where the exchange
rate at each point in time is determined by past inflation. Brazil, Colombia and Chile are the
prime examples (although it should be noted that Brazil and Colombia abandoned it in the
1990s). The central objective is to stabilize the real exchange rate. The major drawback,
however, is the possible loss of control over inflation. For example, assuming zero external
inflation, if the exchange rate is devalued pari passu with inflation, the real exchange rate would
be constant over time. However, under these circumstances, the monetary authority would be
21
ready to accommodate any inflation rate. Hence, inflation would be determined by private
sector’s expectations, not by policy. There would a complete loss of a nominal anchor.18
VI. Fundamental Considerations
For the sake of completeness, I will now review the role of policies which are essential
for the sustainability of any MEP.
1. Fiscal Policy
Consistency between monetary and fiscal policy is essential. It would be very difficult to
implement a low-inflation policy with a large fiscal deficit. This is well understood. Much less
understood, however, is the fact that fiscal deficits may be a poor measure of the fiscal stance.
For example, during capital-inflow periods the fiscal deficit tends to shrink by the simple
fact that private expenditure rises, leading to higher tax revenue. However, as capital inflows
give way to capital outflows, the opposite happens, and large deficits may arise.19 Another
example, which is even more relevant for Mexico, is linked to the rapid expansion in bank credit
that usually takes place during a surge of capital inflows. Since banks have a limited ability to
monitor new loans, the surge in credit is likely to lead to an increase in the share of
nonperforming loans. Unfortunately, this may only become apparent when capital flows out.20 If,
as in Mexico, the fiscal authority bears the burden of nonperforming loans, the fiscal deficit rises.
18 A recent and thorough review of the theory and practice of this type of system can be found in J. Williamson TheCrawling Band as an Exchange Rate Regime: Lessons from Chile, Colombia, and Israel (Washington, DC: Institutefor International Economics, October 1996).
19 For a more detailed discussion, see E. Talvi “Exchange-Rate-Based Stabilization with Endogenous FiscalResponse,” manuscript, Inter-American Development Bank, September 1995.
20 For evidence on this phenomenon, see L. Rojas-Suarez and R. Hausmann Banking Crises in Latin America(Washington, D.C.: Inter-American Development Bank, 1996).
22
The main lesson from these examples is that to make sure that the fiscal stance is
compatible with the adopted MEP, one has to take account of cyclical factors and contingent
government obligations.
2. Domestic Public Debt
A brief history of the domestic public debt in Latin America after World War II would
run as follows: (a) first it was held mostly by the central bank or involuntarily held by pension
funds, (b) in the 1970s such debt starts to be placed in commercial banks, and, finally, (c) in the
1990s domestic public debt starts to be placed outside banks, e.g., firms, private pension funds,
and foreign investors, all on a voluntary basis.
As a result, the dynamics of domestic public debt has radically changed. Witness the
Tesobono crisis. In a globalized economy, where investors have many investment options, the
demand for a given asset (e.g., Mexico’s domestic public debt) is likely to be very volatile. A
simple rumor could set off a massive run against such asset.21 Thus, if under those circumstances
the central bank is supposed to come to the rescue of the fiscal authority, money supply will have
to increase to service expiring debt and finance the fiscal deficit. To keep the MEP in its tracks,
the central bank should have enough international reserves or international credit lines (with the
IMF, for example) to cover these contingencies. As was seen before, the stock of short-term
public debt in Mexico is quite sizable with respect to net international reserves, which highlights
the importance of a substantial, and hopefully fast, accumulation of reserves.
3. Financial Sector
There is no clear reason for the banking sector in Latin America to be largely local, i.e.,
with funds obtained from local depositors and loans made to local firms. However, this system
21 For a recent discussion of these issues, see G.A. Calvo and E.G. Mendoza “Rational Herd Behavior and theGlobalization of Securities Markets,” manuscript, March 1997.
23
prevails in several countries, including Mexico. A heavy dependence on the local markets makes
those banks very sensitive to local cyclical conditions. Thus, banks which should help
smoothing out the business cycle end up contributing to it in a perverse manner.
Moreover, in an increasingly globalized financial world, domestic residents have greater
options to diversify their portfolio. Thus, if local banks have a highly concentrated portfolio,
domestic residents will tend to invest abroad (capital flight). This implies that local banks will
have a great difficulty to grow and sustain a growing economy. Large firms and multinationals
will not be much hurt, because they have better access to international credit. But small- and
medium-sized firms most likely will. One way to remedy this situation is to encourage or, at
least, not to discourage ownership of local banks by international banks.
As noted above, a large domestic financial sector -- if stable -- helps to attenuate the
impact from changes in the conditions of international capital markets, particularly when the
country is subject to runs of the Tesobono variety.
VII. A MEP for Mexico
1. General Considerations
a. As emphasized by the above discussion, the choice of MEP is highly dependent on the
track record of policymakers and institutions. Moreover, memory is still fresh in Mexico
about 1994 difficulties. Thus, for credibility’s sake MEP has to be designed so as not to
raise suspicions about its being unduly accommodative. In particular, I believe that
interest-smoothing is inadvisable because it was the proximate cause of the 1994 crisis.
This policy works well under normal circumstances but it is highly ineffective when the
economy faces currency or bank runs.
b. Mexico is still going through adjustment linked to deep reform. There are important
pending issues, not the least of which is resolving the banking crisis. Thus, I see no
compelling reason to give high priority to lowering inflation to international levels. In
24
this respect, the current policy of using seignorage for accumulating international reserves
seems very sensible.
c. Reserve accumulation is only one of the possible strategies to increase the effectiveness
of MEP. Other policies are to issue longer maturity debt and induce a shift toward longer
maturity deposit structure. This could be facilitated by indexation. In fact, with long
maturities one could achieve a uniform and low debt service schedule which would
reduce the precautionary stock of international reserves.
d. Under the present conditions, all deposits are de facto insured by the central bank at no
(marginal) cost to banks. This is a distortion which could be attenuated by explicit
deposit insurance, whereby banks are charged a fee as a function of their total deposits
and riskiness of their loan portfolio (another reason for raising reserve requirements is
given in point 2.g below). This measure is complementary to the Basle-type capital-
adequacy ratios. Alternatively, one could set a positive reserve requirement which could
be a function of asset riskiness and deposits’ maturity structure.
2. A Proposal
a Set a floor to the nominal exchange rate, and intervene only when the exchange rate hits
the floor so as to prevent the exchange rate from falling below the floor.
b. Money supply (e.g., Base) should be targeted as in the present Banxico monetary
program, if the exchange rate is above the floor. The target, however, should be
announced over a longer horizon (i.e., not one year as at present but, for example, three
years). Moreover, new targets have to announced long before the expiration of the
previous one (e.g., one year).
c. If the exchange rate hits the floor, money should expand by whatever is necessary to keep
the exchange rate on the floor. The exchange rate will not leave the floor until money
supply is on target. This means that all the monetary expansion associated with keeping
25
the exchange rate from falling below the floor will have to be reabsorbed before the
exchange rate is allowed to rise above the floor.
d. The “programmed” inflation rate is computed as in the present Banxico program.
e. The floor could initially be set at, for instance, 3 percent below the current exchange rate.
Let us define the “net rate of inflation” as the rate of domestic inflation minus
international inflation, and the “net programmed rate of inflation” as the difference
between the programmed rate of inflation and expected international inflation (at the time
of making the monetary program). Then, the floor should increase by the net
programmed rate of inflation plus some fraction of the difference between some index of
past net inflation and the net programmed rate of inflation. Thus, assuming that the
actual and expected international rates of inflation are equal to zero, if, for example, the
inflation index is 20 percent, and the programmed rate of inflation is 15 percent per year,
the floor should increase by more than 15 but less than 20 percent. The floor will never
be allowed to increase at a rate larger than a given maximum (e.g., 25 percent per year).
(For more technical discussion, see Appendix II.)
f. Given the low credibility enjoyed by Banxico, the formulas used to update the floor of the
exchange rate should be public information. Besides, the formula should be as simple as
possible.
g. Interest rates should fluctuate freely. To keep the economy from high-interest traps, one
should quickly implement the longer-maturity policies highlighted under 1.c. above.
Besides, I would favor a ‘cleaner’ float in which Banxico sets money supply and,
essentially, closes Banxico’s discount window.
h. Foreign exchange intervention should be nonsterilized. In other words, extra liquidity
created to keep the exchange rate from crashing through the floor should not be mopped
out by issuing domestic debt.
i. To prevent bank credit from rising excessively rapidly, periods of heavy foreign exchange
intervention could be accompanied by a rise in marginal reserve requirements.
26
j. Aside from the previous policy, there should be no controls on capital mobility.
VIII. Comparison with Present System, Clarifications and Critique
1. The key difference between my proposal and present MEP is the explicit floor on the
exchange rate and explicit statement that Banxico will not intervene to stop the exchange rate
from rising. Ideally, aside from programmed foreign exchange purchases, Banxico should
refrain from intervening both directly (in the foreign exchange market) and indirectly
(through manipulation of some key interest rate).
2. I would also favor phasing out the day-to-day accommodation of the monetary base, and
replacing it by a system of minimum (remunerated) reserve requirements and fixed (set in
real terms) penalties from noncompliance. This has the advantage of forcing banks to keep a
safe liquidity ratio. Under normal circumstances, this system may not be much different from
the present. However, it puts additional bounds on banks’ overborrowing from the central
bank as a result of holding an excessively risky asset portfolio (this gets especially
exacerbated during a crisis). Moreover, the incidence of overborrowing from the central
bank is likely to be higher for banks that start from a weak financial situation, unless bank
supervision is very good and effective (both of which are questionable in Mexico).
3. The floor intends to cushion the economy from major and sudden appreciations of the
currency beyond the current levels. Empirical estimates seem to agree that inflation has eaten
up much of the real depreciation brought about by the December 1994 crisis. Thus, further
appreciation will tend to undermine the credibility of the MEP. Parallels will start to be
drawn to the December 1994 crisis, and the public will start to fear that a similar crisis is in
the offing. In this context, and without a clear intervention rule, attempts to devalue the
currency may be seen as a sign of policy weakness. Hence, the clear intervention rule
involved in my proposal should enhance Banxico’s credibility.
27
4. My proposal does not require an immediate major fiscal adjustment. However, as will be
noted in the ensuing sections, increasing the fiscal surplus is the best way to enhance policy
credibility.
5. The exchange rate floor is allowed to slide, but it accommodates less than 100 percent
inflation differentials. Besides, there is a maximum rate of crawl permitted. This avoids
falling into a high inflation trap.
6. My proposal emphasizes transparency. This is achieved by making longer horizon
announcements and staggered them in such a way that the “surprise” element is minimized.
Moreover, above the floor, the exchange rate has to fluctuate freely. The public could first be
shocked by wide exchange rate fluctuations. However, there are financial arrangements (e.g.,
currency futures) that allow individuals to hedge, helping to cushion the real disruptions that
exchange rate fluctuations may otherwise cause.22
7. The relevance of transparency for policy credibility will become more apparent as
presidential elections are approached.
8. The proposal might result in higher exchange rate volatility, although it is likely to lower
interest rate volatility. Moreover, higher exchange rate volatility can be partially dealt with
by trading in currency futures.
9. A possible criticism of setting a floor for the exchange rate is that, once the floor is hit,
investors face one-sided bets: there is only depreciation risk. Thus, when the exchange rate
hits the floor the nominal interest rate is likely to rise. However, as the exchange rate hits the
floor, Banxico would likely intervene to keep it from further appreciating. This implies
22 The private sector will be shocked by wide exchange rate fluctuations if it believes that Banxico is the first one todislike them. But after several episodes in which the exchange rate exhibits wide fluctuations and Banxico expressesits indifference, they will realize that those fluctuations do not reflect the monetary authority’s inability to conductmonetary policy, and will learn to live with them. Something similar happened in Argentina during theConvertibility Program. Since in that program the exchange rate is fixed, fluctuations were reflected in the stock ofinternational reserves. The first time reserves took a sizable plunge (in 1993), panic arose. But once the publicrealized that the central bank was indifferent to it and explicitly expressed that in public, individuals learned to livewith those fluctuations, and the latter stopped making headlines. (International reserves again hit the headlines, ofcourse, during the Tequila crisis.)
28
reserve accumulation which, since it would not be sterilized, increases the fiscal surplus,
improving the credibility of government. The latter, in turn, may further strengthen the peso
and lower devaluation risk, reducing interest rates.
IX. A MEP for Mexico: Where Do We Go from Here?
The above proposal takes into consideration factors that I consider central to Mexico at
present. At present,
1. Mexico does not exhibit a strong financial sector,
2. international reserves are low relative to potential short-term financial obligations that will
have to be borne by government,
3. the economy is still going through a transformation process that may call for sharp changes in
relative prices, and
4. policymaking does not enjoy a high degree of credibility.
The relevance of these points, however, should tend to vanish over time if the policies
advocated here are effective. International reserves should rise because seignorage will be used
for that purpose; on the other hand, potential short-term financial obligations should fall as the
maturity of government debt increases. Furthermore, as reform takes place, relative price
volatility should subside, all of which should be reflected in higher policy credibility.
A key implication is that inflation should be expected to fall over time, eventually
reaching international levels. Thus, the question that arises is, should Mexico eventually adopt a
Currency Board or Dollarize, or should Mexico adopt a system of flexible exchange rates like
Canada, subject perhaps to implicit bands?
1. A MEP for Mexico in the Long Run.
If Mexico’s banks could become full members of the US financial system, or got closely
integrated with the international financial system, then moving to a Currency Board or full
dollarization would be attractive from a purely financial point of view. Thereby, having removed
29
the temptation to use Banxico’s credit for fiscal purposes, fiscal authorities would be subject to
tighter discipline, lowering the probability of creeping inflation. However, Mexico is still
unlikely to get the fiscal support and free labor migration enjoyed by a State in the US. Thus, the
lack of monetary independence would imply that devaluation would be totally forsaken and, with
it, the chance of using it (1) to lower the international value of peso obligations, and (2) to help
reversing real exchange rate misalignment.
Consequently, I see the optimal MEP in Mexico in the long run relying on the peso as an
independent money. Despite the much stronger position of the peso under post-reform
conditions, I still do not see a Currency Board or the like as ideal. In the first place, I believe it is
unlikely that Mexico gets deeply integrated into the US financial system. In the second place,
unless labor migration constraints are substantially relaxed between the US and Mexico, the cost
of misalignment and real shocks in general could be large in absence of monetary policy
independence.
Of course, it could be argued that it is only large shocks and misalignment that should
worry policymakers and hence that, under normal circumstances, the best would be to peg the
peso to the US dollar. Moreover, to prevent large misalignment, needed MEP flexibility could
be achieved by safety valves allowing currency devaluation in exceptional circumstances.
However, experience in Argentina, for example, suggests that after a currency peg is adopted it is
very hard to move away from it. Therefore, the safety valve idea, although not devoid of interest,
is likely to be of limited practical value. The abandonment of the currency peg, albeit
momentarily, is likely to be the cause of further disruption, not just the swift solution to the
problem.
Therefore, I would favor a system of floating exchange rates accompanied perhaps with
more active ‘leaning against the wind’ monetary policy than I would recommend at present
(which could be afforded in the long run due to the greater credibility and stronger financial
stance achieved in the long run).
2. Transition
30
Simplicity and transparency should have the upper hand. The rule adopted should stay in
place for a long period of time. Fine tuning is the enemy of credibility, and Mexico should not
spend its limited credibility capital on monetary engineering. Besides, the dynamics of the
Mexican macroeconomy coupled with that of financial markets are not well understood. Risking
the chance of confusing the ‘market’ by fancy footwork could be dangerous.
Banxico should have inflation targets that go beyond one year. As far as possible,
inflation should be relatively stable and declining. Key for Mexico in the near future is showing
that it can capitalize on free market reforms, deepen the reform process and, as a result, grow on
a sustained basis. MEP should support that key effort, not be a source of confusion and attendant
credibility syndromes.
As financial targets are achieved, reform has worked its way through the economic
system, and the new set of equilibrium relative prices is established, the time will have arrived
for launching a final attack on inflation. However, the pace at which price stability should be
achieved will depend on the circumstances prevailing at the time. Critical factors would be (1)
oil prices and Mexico’s dependence on oil revenue, and (2) the effectiveness of the ruling party.
31
Appendix I. Variability of Interest and Exchange Rates: A Simple Model
Consider a standard demand for money function such that
mt = et - αrt + kt , (1)
where α is a positive coefficient, and m, e, r and k stand for the log of nominal money demand
(= supply , in equilibrium) and the nominal exchange rate, the domestic one-period nominal
interest rate, and a random term reflecting shifts in money demand. Subindex t denotes time.
Thus, given m and k, there is a tradeoff between the volatility of the exchange rate and that of the
nominal interest rate. In particular, if the exchange rate e is very stable, the brunt of the
adjustment to random shocks in equation (1) will have to be borne out by the nominal interest
rate r.
Let us now assume for simplicity that the international interest rate is equal to zero.
Then, the interest rate parity condition under rational expectations is:
Et et+1 - et = rt , (2)
where Et denotes the mathematical expectations operator from the perspective of period t.
Thus, if currency expectations are stable and independent of the current conditions then, by (2),
there should be an inverse relationship between e and r (contrary to Figure 11). Thus, to
rationalize Figure 11, one could assume that Et et+1 is positively associated with et and the
coefficient is larger than unity.
To study the volatility of the exchange and interest rates under different MEPs, I will
examine the polar cases of fixed and flexible exchange rates, and I will abstract from credibility
issues. Fixed exchange rates implies et = a constant. Thus, by (2), rt ≡ 0, and both rates exhibit
a zero variance. Consider now the case of floating exchange rates. For the sake of concreteness,
I will assume a constant money supply, i.e., mt ≡ M for some constant M. Assuming that Et kt+1
= 0, it follows from (1) and (2) that Et et+1 = M. Therefore, by (2), the variance of the two rates is
the same and, by (1), equal to the variance of k divided by 1 + α.
32
Appendix II. The Crawling Peg Formula
Here I will present a justification for the crawling-peg formula in the Proposal,
paragraph e.
Let π and πP denote some index of recent domestic inflation, and programmed domestic
inflation, respectively. Similarly, let π* and π*P denote some index of recent international
inflation, and expected international inflation (at the time of drawing the monetary program),
respectively.
Let us denote the rate of crawl of the floor by ε. Then, paragraph d implies setting ε such
that:
ε = πP - π*P + θ(π - π* - πP + π*P), where 0 < θ < 1. (1)
Thus, if there is no prediction error, the rate of crawl equals the difference between domestic and
international inflation. But if the actual difference exceeds the one in the program, then the floor
grows faster.
Notice that a PPP rule applied to the floor would set θ = 1. In such a case,
ε = π - π*. (2)
In words, a PPP rule would set the rate of crawl equal to the difference between domestic and
international inflation. However, formula (1) implies leaning against the wind but with a slope
less than unity. Thus, we would allow the real exchange rate (respective to the floor) to
appreciate or depreciate, but not by as much as it would occur if the rate of crawl was rigidly set
ex ante.
This can be further clarified by rewriting formula (1) in the following manner:
33
ε = (1 - θ)(πP - π*P) + θ(π - π*). (3)
Thus, the rate of crawl is a weighted average of the programmed and actual
domestic/international inflation differential. The PPP rule would give full weight to the actual
differential, while a rigid ex ante rule would give full weight to the programmed or expected
differential. Furthermore, the (continuous-time) rate of growth of the real exchange rate with
respect to the floor is given by
ε + π* - π = (1 - θ)(πP - π*P - π + π*). (4)
Finally, in order to prevent falling into a high inflation trap, we set a maximum for ε,
denoted by εM, such that ε is determined by formula (1) if the implied ε < εM; otherwise, we set
ε = εM.
34
0
5 0
1 0 0
1 5 0
2 0 0
-1 .2 -1 .0 -0 .8 -0 .6 -0 .4
In f la t io n
R e a l E xc ha n ge R a te
F igu re 1 . M e x ic o . In f la t io n a n d R e a l E xc ha n g e R a te J a n 1 9 8 5 -
Re a l E xc ha n g e Ra te is th e log o f M e xic o to U S C P I in d o lla r s ;In f la tio n is th e y e a r o ve r y e a r C P I w ith 6 m o n th s le a d .
0
5 0
1 0 0
1 5 0
2 0 0
-1 .2
-1 .0
-0 .8
-0 .6
-0 .4
8 5 8 6 8 7 8 8 8 9 9 0 9 1 9 2 9 3 9 4 9 5
In f la t io nR e a l E xc ha n ge R a te
F igu re 2 . M e x ic o . In f la t io n a n d R e a l E xc ha n ge R a te
R e a l E xc h a n g e Ra te is th e lo g o f M e xic o to U S C P I in d o lla r s ;In f la tio n is th e y e a r o ve r y e a r C P I w ith 6 m o n th s le a d .
35
0
20
40
60
80
89 90 91 92 93 94 95
Figure 3. CETE (28 days) Interest Rate
Tequila Crisis--->
0.E+00
1.E+08
2.E+08
3.E+08
4.E+08
5.E+08
6.E+08
76 78 80 82 84 86 88 90 92 94 96
Figure 4. Mexico. Central Bank Loans to Deposit Money Banks(deflated by the CPI)
Tequila Crisis--->
36
0
2
4
6
8
85 86 87 88 89 90 91 92 93 94 95 96
Figure 5. Mexico. Peso/D ollar Exchange R ate
-80000
-40000
0
40000
80000
120000
92:01 92:07 93:01 93:07 94:01 94:07 95:01
m onetary base
gross international reserves
net dom estic credit
b illions of nuevos pesos
F igure 6. M onetary Base, Foreign Reserv es, and Dom estic Credit of the Bank of M ex ico
Tequila Crisis--->
37
0
20000
40000
60000
80000
100000
120000
140000
88 89 90 91 92 93 94 95
gross foreign reservesshort-term public debtM2
Figure 7. Mexico: Money and Debt Imbalancesmillions of U.S. dollars
2
4
6
8
10
89 90 91 92 93 94
Figure 8. Interest Rate on US Treasury Bill
38
-0.4
-0.2
0.0
0.2
0.4
0.6
70 72 74 76 78 80 82 84 86 88 90 92 94 96
Figure 9. Mexico. Monthly Change in Monetary Base (logs)
-0.6
-0.4
-0.2
0.0
0.2
0.4
0.6
95:07 95:10 96:01 96:04 96:07 96:10
Figure 10. Mexico. CETE (91 days) Interest Differential with U.S. T-Bill
39
-1
0
1
2
3
-0.10 -0.05 0.00 0.05 0.10 0.15
Devaluation
Change in CETE-91 Interest
Figure 11. Mexico. Devaluation and Change in CETE Interest June 1995 - December 1996